As a business owner, it’s essential to understand the various components that go into the valuation of your company. Your business valuation will have a direct impact on how much you receive for your company when it’s time to sell.
One thing your advisor is sure to discuss with you is working capital (WC). The concept of working capital may be pretty straightforward, but it can become complicated when considering the role it plays in mergers and acquisitions (M&A).
So, just what is working capital? This article will answer that question and more for business owners. You’ll learn what WC is, how it impacts businesses in the lower middle market (those with revenues between $5 million and $25 million), how it’s calculated, what working capital value can tell you about your business, and its role in the selling process.
What Is Working Capital and What Does It Tell You About the Value of Your Business?
Working capital is a metric used to help determine a company’s liquidity, short-term financial health, and operational efficiency. You may also see it referred to as net working capital or NWC. Working capital measures a company’s current assets minus current liabilities. From a financial perspective, “current” refers to the time period of the past 12 months.
This figure can offer a few insights into business operations. If a company has positive working capital, then it has enough cash on hand to grow. Having cash on hand — cash that is accessible or liquid — allows businesses to expand operations or invest in research and development.
That said, if a company’s working capital is too high, it may not necessarily be a good thing. This could indicate that the company has poor inventory management, as it is creating a backlog of finished goods — goods that have gone through the manufacturing process but have not yet been sold, thus requiring storage space. It could also demonstrate that a company is not reinvesting its cash properly. Your advisor will compare your working capital to other similar companies in your industry to determine whether your working capital is too high.
Negative working capital could be a red flag, as it indicates that a company owes more to lenders than it currently has in liquid assets. Though it varies from company to company, negative WC could indicate that a business is having trouble fulfilling its financial obligations, such as paying for operational expenses.
How Is Working Capital Calculated?
We’ve answered, “What is working capital?” Now, let’s take a look at how it’s calculated. The working capital formula is pretty straightforward:
Working Capital = Current Assets – Current Liabilities
Examples of current assets include:
- Cash on hand
- Finished goods and inventory
- Raw materials
- Accounts receivable
- Any asset that could be liquidated and converted to cash in less than a year
Examples of current liabilities include:
- Accounts payable
- Taxes payable
- Lines of credit
- Credit cards
- The current portion of long-term debt that’s due within a year (such as rent if you are signed onto a lease)
Current assets may also be referred to as short-term assets. Similarly, current liabilities may also be referred to as short-term liabilities.
Your advisor can determine your working capital by looking at financial statements like your balance sheet.
You may also see working capital expressed as a financial ratio. This is likely referred to as the current ratio or the working capital ratio:
Working Capital = Current Assets ÷ Current Liabilities
This ratio essentially offers the same comparison as the working capital formula. If your advisor opts to use the ratio over the formula, they will be looking to see if the yield is greater or less than one. If it is greater than one, a company has a positive cash flow. Current assets are greater than liabilities. If it is less than one, liabilities are greater than assets.
How Does Working Capital Impact the Sale of a Business?
In the lower middle market, there’s a strong chance that your company is going to sell in an asset sale versus a stock sale. This means that your assets will be broken down and sold individually. You, as the seller, are still responsible for outstanding liabilities, such as debts associated with lines of credit.
So, if liabilities aren’t being purchased in an asset sale, how does working capital apply to the sale of your business?
During the M&A process, buyers will want to know the average amount of working capital for your business. Working capital is never static. In fact, it could technically change daily. Buyers will want to know your average amount of working capital over a specific period, typically a year.
Why do they want to know this information? Because they want a certain amount of working capital left in the business when they take ownership. Think of it like this — when you buy a new car, you expect there to be enough gas in the tank for you to drive it off the lot. Likewise, when you sell your business, you should also leave some “gas in the tank.”
To look at it from a more technical perspective, a buyer is purchasing your assets. This can include short-term assets like raw materials as well as long-term assets, such as pieces of equipment. But the buyer is not purchasing the cash you have in your business bank accounts, nor is the buyer purchasing your accounts receivable. Both cash and accounts receivable likely play a vital role in your working capital management.
There will be liabilities that exist as soon as the new buyer takes over the company as well. For instance, they may have to pay wages to any employees they’ve kept on board. Buyers have a reasonable expectation that there will be enough working capital in place to keep the day-to-day operations of the company in place (if, of course, this is their desire).
Working capital is a critical part of the sales process and can often be one of the most contentious parts of the negotiating process. Buyers typically want anywhere from a couple of months up to a year’s worth of working capital left in the business at the time of the sale. However, every dollar you leave behind in working capital is a dollar not in your pocket.
It’s crucial that the team of advisors negotiating your sale are clear about the expectations for working capital and communicate those expectations to the buyer’s team. Working capital could end up raising the purchase price and costing the buyer considerably more. For instance, the buyer may need to get a loan to buy a business for $4 million, but then they might need to get additional financing for WC. So in effect, that increases the purchase price.
Understanding Working Capital Can Help With the Sale of Your Business
What is working capital? Simply put, it’s the measure of your company’s operational efficiency. If your WC is positive, your current assets are greater than your current liabilities. This not only ensures you can meet your short-term obligations, but that you can also reinvest and grow your business. If the figure is negative, then you owe more in short-term debt than you can pay. You need to find ways to increase cash flow to help meet your financial obligations.
Understanding WC demonstrates why it’s critical for businesses to have annual valuations done by a trusted advisor. Business valuations serve as a measuring stick that offer feedback about your company so you can make strategic financial decisions moving forward — even if you don’t think that you’re quite ready to sell.
Allan Taylor & Co. can guide you through the entire sales process, from prep work years in advance to closing the deal. Contact us today to learn more about how we can help.